The Federal Reserve rising interest rates by half a percentage point on December 14, 2022, within a range of 4.25 to 4.5%, the seventh increase this year. So far in 2022, the Fed has raised its benchmark short-term rate, which influences most other borrowing costs in the economy, by 4.25 percentage points from a low near zero too. recently than in March.
But even as the U.S. central bank raises rates — and plans to continue to do so in 2023 — buyers are starting to notice a pleasant surprise: Mortgage rates have fallen.
What’s going on?
We asked Brian Whitea professor of finance who has research mortgage rates and bank loansto explain the paradox of falling mortgage costs in times of rising base interest rates.
What’s going on with mortgage rates?
After skyrocketing for much of 2022, mortgage rates and other long-term rates are starting to fall.
The average rate for a 30-year mortgage fell 0.75 percentage points over the past month or so, after hitting a 20-year high of 7.08% in early November. Rates hit 6.33% on December 8, the lowest level since September. This happened during the same period the Fed raised its benchmark interest rate by 2 percentage points.
Another policy rate that has fallen is the yield on 10-year Treasury bills, which decreased by a similar amountat 3.5%.
Why are mortgage rates falling if the Fed keeps climbing?
The short and rather boring technical answer is that bond markets priced in this rate hike several months ago. And since market factors largely dictate borrowing costs, the increase has already been absorbed by home loan rates.
Mortgage rates, while on the rise due to the Federal Reserve’s rapid rate of hikes, are actually more closely tied to the interest rate on treasury securities, in particular the yield on the 10-year Treasury bond. This stock started pricing in Fed interest rate hikes a year ago and increased by less than 1.5% in December 2021 over 3.25% in June.
And now, with signs that inflation has already peaked and amid growing worries of a slowing economy, those longer-term rates are falling in anticipation of fewer future Fed rate hikes than planned a short time ago. In fact, mortgage and other long-term rates could continue to fall over the next few months – assuming the Fed manages to get inflation under control so it can lower its benchmark rate again.
Why do mortgage rates follow the yield of 10-year Treasury bills?
Although 30-year mortgages can be held for three decades, most people sell their home or refinance in less than a decademeaning that the investor receiving the mortgage payments is effectively investing in a 10-year bond.
Therefore, the average 30-year fixed rate mortgage interest rate is normally 1 to 2 percentage points more than the yield on 10-year Treasury bills.
However, when the economy is more uncertain than usual, such as earlier this year, this gap can reach 3 percentage points. This uncertainty may be the result of a potential economic crisis slow-downthe possibility of the Fed raising rates more than expected, inflation, Changes to the Fed’s balance sheet or all of the above – as happened in 2022.
Why are mortgage rates higher than Treasury yields?
Since the U.S. Treasury is more likely to repay investors than almost any individual owner, investors charge a higher interest rate because of the extra risk they take.
Even if individuals turn to banks to borrow, banks often sell these investor loanswho then receive the money that the individuals repay on the loan.
Since individuals default on mortgages more often than the U.S. government defaults on Treasuries, investors require a higher yield to purchase the rights to receive the payments of these mortgages.
If mortgage rates fall, will the Fed have to raise rates further to control inflation?
The decline in mortgage rates preceded an increase in the home purchase index, which is a measure of current market developments conditions to buy houses. This suggests the the housing market could finally regain strength after slowing all year.
Since the Fed is trying to slow down the economy activity to bring inflation down could drive up house prices rise again, forcing the Fed to raise its key rate more than expected.
However, I believe that the effective fed funds rate, which is the market rate directly influenced by the Fed’s target range, is already sufficiently restrictive slow the housing market and restore more normal economic conditions in 2023. Moreover, the decline in mortgage rates is still quite small – they remain more than double what they were a year ago – so the decline probably won’t have much impact on its own.
What the Fed itself thinks of this challenge – and where it projects be interested rates next year – that’s what me and many others economists and investors will follow closely after his last meeting in 2022. He should tell us what to expect in 2023 – so stay tuned.
Article updated to include Fed increase rates.
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D. Brian Blank does not work for, consult, own stock or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond his appointment university.